risk adjusted capital management

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Deloitte &

Touche

Risk-Adjusted Capital

ManagementCAS/SOA ERM Symposium

July 30, 2003

Sim Segal, FSA, MAAA

Senior Manager

Deloitte & Touche


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Agenda

! What is capital management?! The capital management process and its evolution! Practical application of capital management! Keys to success


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Capital has two components

Capital is wealth . . .

. . .usedor availablefor use . . .

. . . in the production of more wealth.

American Heritage Dictionary


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Assets

Total Capital = Required + Available

UsedRequired capital

Available capital

Total

capital

Liabilities

Available

for use


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Capital management is managing bothrequired and available capital

Required capital

management

Available capitalmanagement

Maintain available capital at

optimal level, balancing:

a) Future growth needs

b) Drag on returns

c) Capital flexibility

Maximize risk-based capital

performance measure, within

constraints


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Capital management is managing bothrequired and available capital

Required capital

management

Maximize risk-based capital

performance measure, within

constraints

Maintain available capital at

optimal level, balancing:

a) Future growth needs

b) Drag on returns

c) Capital flexibility

Focus of todays

discussion

Available capitalmanagement


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Agenda



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The Capital management process has fivesteps

1.Define required capital

2. Allocate required capital

3. Select a capital measure to evaluate performance

4. Set a hurdle rate

5. Maximize capital measure, within constraints


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Capital management has evolved in theinsurance industry

1. Required Capital 2. Capital Allocation 3. Capital Measure 4. Hurdle Rate

Zero (ignored in pricing)

Multiple of RBC(Statutory)

Multiple of RBC plusaccounting adjustments

(GAAP, but Stat-based)

Value-at-Risk (VaR)(GAAP)

Company level

Segment level

Line of business orproduct line level

Policy level

Customer level

Producer level

Internal Rate of Return(IRR)

Return on Investment(ROI)

Return on Equity (ROE)

Return on Capital (ROC)

Benchmark

Long-Term WeightedAverage Cost of Capital

(WACC)

WACC based ondynamic risk-free rate

WACC based ondynamic risk-free rate

and

dynamic risk premiumEmbedded Value (EV) or

Fair Value (FV)


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Agenda



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Example: Public Multiline Financial, Inc.

Step 1:Define required capital


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Downgradebyrating

agency

Economicruin

?

??

?

Required capital is risk-based . . . but what riskis being addressed?


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Required capital addresses multiple risksrelated to disparate constituencies

Regulatory Capital

Rating Agency Capital

Benchmark Capital

Economic CapitalTotal

Required

Capital

To avoid regulatory

action

To maintain current

debt or financial

strength ratings

To maintain a givenprobability of

avoiding ruin

To match the capital

level of a key

competitor


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Step 1:Define required capital

Required capital is Value-at-Risk (VaR), using a one-yeartime horizon and a 99.9% confidence level


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Step 1: Define required capital

Step 2: Allocate capital


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Allocating capital further down in theorganization facilitates more decision-making

Strategic decisions, e.g.:

!Growth!Market exit

Tactical decisions, e.g.:

!Pricing!Mix of product portfolio

Transactional decisions, e.g.:!Retention efforts!Cross-selling!Producer compensation decisions

Policy

Product

Policy Policy. . .

Product Product. . .

Policy

Segment Segment Segment. . .


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Capital is allocated down to the product level


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Step 3: Select a capital measure to evaluate performance


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Each capital measure offers a unique focus

#ROI emphasizes rate of return#ROE measures efficiency of usage of equity capital#ROC illustrates the ability to generate earnings per dollar

of total capital

#EV quantifies the dollar contribution to shareholder value


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Case study: ROE-based compensation hasdisadvantages vs. EV-based compensation

Hurdle rate = 15%

Situation ROE-based* plan EV-based plan

Value is created:Management in a 20% ROE line of business

decides to add a 16% ROE project

Penalized Rewarded

Value is destroyed:

Management grows a 12% ROE business

Rewarded Penalized

* Compensation plan based on ROE and earnings


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Capital measure is Embedded Value (EV)


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Embedded

Value (EV)

Value of surplus

Value of inforcebusiness

Discounted value of distributableearnings from inforce business*

Distributablesurplus

* Includes target surplus

Embedded Value (EV) is a function ofdistributable earnings / surplus from inforce


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-3

-2

-1

0

1

2

3

4

0 1 2 3 4 5 6 7 8 9 10

Adjusted statutory net income *

Target surplus released (consumed)

* Adjusted to replace investment income on surplus with investment income on target surplus

Distributable earnings reflects changes in totalsurplus and target surplus


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Step 4: Set a hurdle rate


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The hurdle rate is managements estimate ofits risk-return position on the efficient frontier

Return

Risk

Rf

m

Rm

?

?

0

XX


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Hurdle rate setting methods involve tradeoffsbetween simplicity, accuracy and stability

Method Simplicity Accuracy Stability ofMeasure

Benchmarking Easiest Poor Poor

Long-term weighted average

cost of capital (WACC)

Moderately

complex

Moderate Fair

WACC based on dynamic

risk-free rates

Moderately

complex

High Good

WACC based on dynamicrisk-free rates and dynamic

risk premium

Mostcomplex

Highest Best


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Hurdle rate is WACC based on dynamic risk-free rates, with

uniform hurdle rates throughout the enterprise


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Step 5: Maximize capital measure, within constraints


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Dynamic modeling clarifies potential impact ofprojects on embedded value (EV)

($millions)

Product EV EV

Line Investment Mortality Expense Lapse Baseline Chg

A -2% 245.3 2.5

B 0.10% -1% -5% -2% 174.9 5.6

C -5% 5% 60.2 (0.6)

D -10% 28.0 0.8

Total LOB 508.4 8.3

Projected Change in Assumptions


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Constraint of maintaining the RBC ratio ismore complex when using Value-at-Risk (VaR)

Required capital

(VaRC)

1.0 B

Available capital

0.3 B

Required capital

(200% RBC)

1.2 B

Available capital

0.1 B

Statutory

GAAP


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Summary: practical applications of capitalmanagement

Strategic:

! Manage stock analysts, e.g., reveal under-valued businesses! Strategic planning, e.g., project capital needs, quantify impact on capital ratios!

Risk management, e.g., estimate probability of ruin and impact on stock priceTactical:

! Funding decisions, e.g., identify stock repurchase opportunities! Risk-return tradeoff decisions! Identifying highest value-added projects! Asset-liability management (ALM)! Provide incentive compensation aligned with increasing value


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Agenda



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Keys to success

# Define required capital with deference to all key constituencies# Allocate capital as far down in the organization as possible# Select a capital measure that aligns with your goals# Align incentive compensation with the capital measure# Avoid fallacy of the correcthurdle rate# Manage constraints carefully while maximizing capital measure# Employ a disciplined process to setting or changing assumptions# Provide management with the tools to understand the impact of

decisions on the capital measure


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CAS/SOA ERM Symposium

July 30, 2003

Sim Segal, FSA, MAAA

Senior Manager

Deloitte & Touche

Risk-Adjusted Capital Management

Thank You!

risk adjusted capital management

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